DBRS Downgrades Vale Ratings to BBB (low), Maintains Negative Trend

DBRS Limited (DBRS) has today downgraded the ratings of Vale S.A. (Vale or the Company) and its subsidiaries to BBB (low) from BBB. The trends remain Negative. The significant deterioration in key credit metrics that DBRS noted in November 2015, when Vale’s long-term ratings were downgraded to BBB, continued in Q4 2015.

Markets for Vale’s key commodities, especially iron ore, continued to deteriorate, which caused further weakening in operating earnings and cash flows. In addition, total adjusted debt as calculated by DBRS rose to $34.3 billion in Q4 2015 from $33.6 billion in Q3 2015. Note that DBRS’s adjusted total debt calculation includes Vale’s obligations to the Brazilian government for tax and social contributions for foreign subsidiary equity gains (REFIS; $4.4 billion in Q4 2015) and adjustments to capitalize operating leases. At 4.7x, adjusted debt-to-EBITDA rose even further beyond the threshold DBRS associates with an investment-grade rating.

Vale’s revised rating remains supported by its substantial business strengths. The Company is the lowest-cost producer of iron ore in the world. In Q4 2015, C1 cash costs improved to $11.90/tonne, the lowest in the sector. Although the continued depreciation of the Brazilian real versus the U.S. dollar has supported the reported cost reduction, years of efficiency enhancement initiatives are also responsible for the excellent cost performance. Vale’s long-term sustainability is underpinned by its long-life, high-grade iron ore reserves, with an average grade of over 50%. The Company achieved sales of over $25 billion and EBITDA over $7 billion in 2015 from assets on six continents. This scale provides substantial financial, labour, and technological resources, and protects the Company from the impact of problems at any particular operation across its portfolio.

Despite some progress made to diversify operating earnings away from its overwhelming reliance upon ferrous minerals in previous years (98% of EBITDA in 2012), this division remains the primary driver of sales (two-thirds of total revenues) and operating earnings (over four-fifths of EBITDA). Nickel, copper and phosphates remain the largest contributors to revenues and EBITDA beyond ferrous minerals. As the current downturn has shown, Vale’s operations remain significantly exposed to cyclical downswings in commodity markets, especially iron ore.

The political risk associated with operating in Brazil is increasing. DBRS today downgraded Brazil’s long-term foreign currency Issuer Rating (see “DBRS Downgrades Brazil to BB (high), Negative Trend” on the DBRS website). Although only 16.9% of sales are generated in Vale’s domestic market, over half of the Company’s assets are located there. There is no direct link between the Government of Brazil’s sovereign credit rating and Vale’s credit rating, primarily due to the global nature of Vale’s business activities and end markets. Therefore, DBRS does not believe that the unfavourable developments in Brazil have a material impact on Vale’s credit profile at this time. However, as the Government’s challenges, such as the sharp increase in the fiscal deficit, become even more acute, the potential for interference in Vale’s affairs increases.

Capital spending and dividend outlays in 2015 of $8.4 billion and $1.5 billion, respectively, were well below previous years. However, the Company still posted a free cash flow deficit of $4.8 billion for the year due to the impact of lower commodity prices, especially iron ore, on operating cash flows. This deficit was financed, in part, by $3.5 billion of funds raised from the divestment of iron ore production and logistics assets, the sale of iron ore bulk carrier ships and gold stream financing. As a result of the challenging market conditions and outlook, Vale plans to deleverage even more aggressively than previously planned. The revised plan includes the exploration of more aggressive options to reduce debt, possibly including the sale of core assets.

DBRS expects the iron ore market to remain oversupplied in the near term, despite expected steel production growth in 2016 in Europe and the United States offsetting further declines in China. The outlook for nickel is also unfavourable, with a paltry Chinese demand outlook and increasing competition from domestic Chinese producers of lower-grade ferronickel substitutes for stainless steel production. Any pricing gains in the copper market are expected to be modest at best.

Thus, any recovery in Vale’s financial profile will likely need to be driven by continued strong output performance and the successful execution of the Company’s debt reduction plan. In 2015, record volumes of iron ore, nickel and copper were produced. The large-scale, low-cost S11D (Carajas) iron ore project should support iron ore volume growth starting in H2 2016 as the Company progresses toward its target of adding 100 MT of annual iron ore production volume by 2019. The Samarco pellet production joint venture may restart by year-end 2016, depending upon official authorizations. So long as operations recommence in line with such a time frame, Samarco anticipates being able to cover the cost of multibillion dollar fines for cleanup and damages without requiring Vale to make cash contributions.

On December 31, 2015, Vale held $3.6 billion in cash on its balance sheet, and had full availability on its July 2018 ($2 billion) and May 2020 ($3 billion) revolving credit facilities. As DBRS noted on January 13, 2016, the Company drew down $3 billion from these lines to support potential cash flow needs arising from the delayed divestment of a stake in the Moatize and Nacala Mozambican coal assets. The Company’s liquidity position remains sufficient.

The severity of the market downturn, especially in ferrous mineral markets, has had a major negative impact on the Company’s financial position, and little relief from the market is expected in the near term. The financial profile has been stretched well beyond the current rating, and DBRS anticipates another free cash flow deficit in 2016 (despite projected capex of only $5.5 billion and cash saved from the revised dividend policy). Key metrics are not expected to recover back into the investment grade range until 2018 at the earliest.

However, it is during such challenging times that the true benefits of being the low-cost producer in the sector are realized. DBRS expects the Company to continue to produce record volumes of low-cost iron ore and pellets in 2016. While this is not expected to halt the cash burn, it will mitigate the impact while assets sales (possibly including core assets) are undertaken to deleverage the balance sheet. The Company has targeted a net debt balance of $15 billion, compared to the net debt position as at December 31, 2015, of $25.2 billion (based on the Company’s unadjusted gross debt calculation of $28.8 billion). DBRS believes that the Company’s plan has merit, and notes that there are several options for significant asset sales, especially since divestments of core assets are now also being considered. If executed as planned, these actions would provide important support to the financial profile.

Therefore, while the downgrade reflects the severity and the ongoing impact of the market downturn on Vale’s operating results and financial profile, and the Negative trend reflects the unfavourable outlook and challenges associated with the Company’s deleveraging plan, DBRS continues to view Vale as a company with a very strong business profile. Should market conditions deteriorate more than expected going forward, or should the Company prove unable to reduce its debt as expected, an additional downgrade may result. Alternatively, should the Company demonstrate success with its proposed asset sales at reasonable valuations, and iron ore markets show some signs of stability/improvement, DBRS would consider a trend change to Stable.

Notes:
All figures are in U.S. dollars unless otherwise noted.

The related regulatory disclosures pursuant to the National Instrument 25-101 Designated Rating Organizations are hereby incorporated by reference and can be found by clicking on the link to the right under Related Research or by contacting us at info@dbrs.com.

This rating is endorsed by DBRS Ratings Limited for use in the European Union.

The applicable methodology is Rating Companies in the Mining Industry, which can be found on our website under Methodologies.

The Senior Unsecured Debt of Vale Overseas Limited is irrevocably and unconditionally guaranteed by Vale S.A.